Monopoly and Oligopoly Obid A. Khakimov okhakimov@wiut.uz

What you will learn in this chapter: The significance of monopoly, where a single monopolist is the only producer of a good How a monopolist determines its profit-maximizing output and price The difference between monopoly and perfect competition, and the effects of that difference on society’s welfare What price discrimination is, and why it is so prevalent when producers have market power The meaning of oligopoly, and why it occurs Why oligopolists have an incentive to act in ways that reduce their combined profit, and why they can benefit from collusion How our understanding of oligopoly can be enhanced by using game theory, especially the concept of the prisoners’ dilemma

Types of Market Structure In order to develop principles and make predictions about markets and how producers will behave in them, economists have developed four principal models of market structure: perfect competition monopoly oligopoly monopolistic competition

Types of Market Structure This system of market structures is based on two dimensions: The number of producers in the market (one, few, or many) Whether the goods offered are identical or differentiated . Differentiated goods are goods that are different but considered somewhat substitutable by consumers (think Coke versus Pepsi).

The Meaning of Monopoly Our First Departure from Perfect Competition… A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly. e.g. De Beers The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power. What do monopolists do with this market power? Let’s take a look at the following graph…

Why Do Monopolies Exist? A monopolist has market power and as a result will charge higher prices and produce less output than a competitive industry. This generates profit for the monopolist in the short run and long run. Profits will not persist in the long run unless there is a barrier to entry. This can take the form of control of natural resources or inputs, economies of scale, technological superiority, or legal restrictions imposed by governments, including patents and copyrights.

How a Monopolist Maximizes Profit The price-taking firm’s optimal output rule is to produce the output level at which the marginal cost of the last unit produced is equal to the market price. A monopolist, in contrast, is the sole supplier of its good. So its demand curve is simply the market demand curve, which is downward sloping. This downward slope creates a “wedge” between the price of the good and the marginal revenue of the good—the change in revenue generated by producing one more unit.

Comparing the Demand Curves of a Perfectly Competitive Firm and a Monopolist An individual perfectly competitive firm cannot affect the market price of the good  it faces a horizontal demand curve DC , as shown in panel (a). A monopolist, on the other hand, can affect the price (sole supplier in the industry)  its demand curve is the market demand curve, DM, as shown in panel (b). To sell more output it must lower the price; by reducing output it raises the price.

How a Monopolist Maximizes Profit An increase in production by a monopolist has two opposing effects on revenue: A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold. A price effect. In order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue. The quantity effect and the price effect are illustrated by the two shaded areas in panel (a) of the following figure based on the numbers on the table accompanying it.

The Monopolist’s Profit- Maximizing Output and Price To maximize profit, the monopolist compares marginal cost with marginal revenue. If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less. So the monopolist maximizes its profit by using the optimal output rule: At the monopolist’s profit-maximizing quantity of output, MR = MC

Monopoly versus Perfect Competition P = MC at the perfectly competitive firm’s profit-maximizing quantity of output P > MR = MC at the monopolist’s profit-maximizing quantity of output Compared with a competitive industry, a monopolist does the following: Produces a smaller quantity: QM < QC Charges a higher price: PM > PC Earns a profit

Monopoly and Public Policy By reducing output and raising price above marginal cost, a monopolist captures some of the consumer surplus as profit and causes deadweight loss. To avoid deadweight loss, government policy attempts to prevent monopoly behavior. When monopolies are “created” rather than natural, governments should act to prevent them from forming and break up existing ones. The government policies used to prevent or eliminate monopolies are known as antitrust policy.

Price Discrimination Up to this point we have considered only the case of a single-price monopolist, one who charges all consumers the same price. As the term suggests, not all monopolists do this. In fact, many if not most monopolists find that they can increase their profits by charging different customers different prices for the same good: they engage in price discrimination.

Perfect Price Discrimination In the case of perfect price discrimination, a monopolist charges each consumer his or her willingness to pay; the monopolist’s profit is given by the shaded triangle.

Some Oligopolistic Industries Economics in Action - To get a better picture of market structure, economists often use the “four-firm concentration ratio” which asks what share of industry sales is accounted for by the top four firms.

Understanding Oligopoly Some of the key issues in oligopoly can be understood by looking at the simplest case, a duopoly. With only two firms in the industry, each would realize that by producing more it would drive down the market price. So each firm would, like a monopolist, realize that profits would be higher if it limited its production. So how much will the two firms produce?

Understanding Oligopoly One possibility is that the two companies will engage in collusion— Sellers engage in collusion when they cooperate to raise each others’ profits. The strongest form of collusion is a cartel, an agreement by several producers that increases their combined profits by telling each one how much to produce. (Acting like single Monopoly) They may also engage in non-cooperative behavior, ignoring the effects of their actions on each others’ profits.

The Prisoners’ Dilemma The reward received by a player in a game, such as the profit earned by an oligopolist, is that player’s payoff. A payoff matrix shows how the payoff to each of the participants in a two player game depends on the actions of both. Such a matrix helps us analyze interdependence.

The Prisoners’ Dilemma The game is based on two premises: (1) Each player has an incentive to choose an action that benefits itself at the other player’s expense. (2) When both players act in this way, both are worse off than if they had chosen different actions.

The Prisoners’ Dilemma Each of two prisoners, held in separate cells, is offered a deal by the police—a light sentence if she confesses and implicates her accomplice but her accomplice does not do the same, a heavy sentence if she does not confess but her accomplice does, and so on. It is in the joint interest of both prisoners not to confess; it is in each one’s individual interest to confess.

Game Theory When the decisions of two or more firms significantly affect each others’ profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory.

The Prisoners’ Dilemma An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. Depending on the payoffs, a player may or may not have a dominant strategy. A Nash equilibrium, also known as a non-cooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players.

The Rise and Fall and Rise of OPEC Economics in Action The Organization of Petroleum Exporting Countries, usually referred to as OPEC, includes 11 national governments (Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirate, and Venezuela). Two other oil-exporting countries, Norway and Mexico, are not formally part of the cartel but act as if they were. (Russia, also an important oil exporter, has not yet become part of the club.) Unlike corporations, which are often legally prohibited by governments from reaching agreements about production and prices, national governments can talk about whatever they feel like.

The Ups and Downs of the Oil Cartel The Organization of Petroleum Exporting Countries (OPEC) is a legal cartel that has had its ups and downs. From 1974 to 1985 it succeeded in driving world oil prices to unprecedented levels; then it collapsed. In 1998 the cartel once again became effective.

Oligopoly in Practice The Legal Framework- Oligopolies operate under legal restrictions in the form of antitrust policy. But many succeed in achieving tacit collusion. Tacit collusion is limited by a number of factors, including large numbers of firms, complex pricing, and conflicts of interest among firms.